What you need to know: On December 16th the SEC approved amendments to its rules to enhance proxy statement disclosure. The new rules will become effective on February 28th and, therefore, will apply to most companies during the 2010 proxy season. The final rules are generally in the form proposed in July 2009 (see Choate Notice regarding the proposed amendments) and address the following items:
- Enhanced disclosure of relationship between compensation policies and corporate risk;
- Changes to the reporting of equity awards;
- Enhanced disclosure about directors and director nominees;
- Additional disclosure about board leadership structure;
- Additional disclosure about compensation consultants; and
- Reporting on Form 8-K of voting results from shareholder meetings.
What you need to do: Companies should assess current compensation and governance practices and policies in light of the new SEC rules and begin promptly to take steps to ensure that the new rules will be properly reflected in their next proxy statement. Companies should also review their directors and officers questionnaires to ensure they elicit all the information required by the final rules to be included in the 2010 proxy statement.
The SEC has approved changes to its executive compensation disclosure rules and other corporate governance enhancements. The primary goal of these changes, which consist of amendments to existing disclosure requirements as well as new requirements, is to improve the disclosure that shareholders of public companies receive with respect to compensation and governance matters.
The new rules will be effective on February 28th and, therefore, will apply to most companies during the 2010 proxy season. There is some uncertainty as to how the effective date will apply in some circumstances (for example, in the case of companies that include compensation disclosure in Part III of a Form 10-K filed prior to the effective date or that file a preliminary proxy statement before February 28 and a definitive proxy statement after). The SEC will presumably provide clarification on these transition issues in the near future.
The new rules are similar to the form in which they were proposed in July 2009, with a limited number of changes as described below. The final rules did not include the changes to proxy solicitation rules that were included in the proposal. The SEC has indicated it will separately consider these in the future.
The most significant of the changes included in the new rules are as follows (differences from the proposed rules are highlighted in italics):
Relationship between compensation policies and risk The new rules include the addition of disclosure in a new section of the proxy statement, separate from CD&A, that will provide information about how a company’s overall compensation policies for its employees (not limited to executive officers) create incentives that can affect the company’s risk and management of that risk. The final rules provide that this disclosure is necessary only to the extent that risks arising from compensation policies or practices are reasonably likely to have a material adverse effect on the company, a standard that the SEC notes is used in its MD&A rules. Importantly, the adopting release explicitly states that a company may under appropriate circumstances conclude that its compensation policies and practices are not reasonably likely to have a material adverse effect on the company.
The final rules differ from the proposed rules in that:
- The final rules continue to limit CD&A to NEO-related disclosure and provide for the company-wide risk related discussion in a separate section;
- The final rules provide that the risk related disclosure is only required if the compensation policies or practices create risks “reasonably likely to have a material adverse effect” instead of the lower standard contained in the proposed rules that would have required disclosure if the compensation policies or practices create risks that “may have a material effect;” and
- The final rules do not require a company to make an affirmative statement that it has determined that the risks from its compensation policies and practices are not reasonably likely to have a material adverse effect on the company.
The adopting release states that the SEC believes that this type of disclosure can help investors identify whether the company has a system of incentives that can lead to excessive or inappropriate risk taking by its employees. Directors, particularly for companies that are not in the financial services industry, historically have not considered compensation policies and practices to be an element of corporate risk management, but now may need to do so. Compensation committees should consider these issues in making compensation decisions and in thinking about how best to analyze and explain the interplay between compensation and risk taking within their enterprise. Compensation committees may find it helpful to review the non-exclusive list contained in the new rules of situations in which compensation programs may raise material risks to companies. For example, these may include policies that vary significantly from the overall risk and reward structure of the company, such as when bonuses are awarded upon completion of a task while income and risk from the task extend over a longer period of time, or compensation programs at business units that either carry a significant portion of a company’s risk profile, have a different compensation structure or are significantly more profitable than other business units in the company.
If disclosure about material risks raised by compensation programs is required, the rules call for a principles-based approach, similar to the CD&A requirements. When disclosure is required, the rules provide illustrative examples of the issues that would potentially be appropriate for companies to address, while noting that disclosure will vary depending on the nature of each company’s business and its compensation approach.
Smaller reporting companies (generally, those with a public float of less than $75 million) will not be required to provide the new disclosure related to compensation and risk.
Reporting of equity awards The Summary Compensation Table and Director Compensation Table disclosure of stock awards and option awards has been revised to require disclosure of the aggregate grant date fair value of awards computed in accordance with FASB ASC Topic 718 (formerly FAS 123R). The revised disclosure replaces currently mandated disclosure of the dollar amount recognized for financial statement reporting purposes for the fiscal year in accordance with FASB ASC Topic 718. This change will be for companies providing disclosure for a fiscal year ending on or after December 20, 2009, and will require the recomputing of prior years’ results that would be reported for current NEOs. This change in disclosure is intended to improve disclosure by focusing on the value of stock awards that are granted in the year rather than the current year accounting for awards granted in prior periods and will result in the disclosure of higher compensation amounts.
The rules provide that the value of performance awards reported in these compensation tables be computed based on the probable outcome of the performance condition(s) as of the grant date, rather than on maximum performance, as was proposed. Disclosure about an award’s potential maximum value, however, must be set forth in a footnote to the applicable table.
The SEC decided not to change the way in which non-cash awards issued in lieu of salary or bonus that an NEO has elected to forego are disclosed. Instead, the grant date fair value of such non-cash awards will continue to be reported in the “Salary” or “Bonus” column of the Summary Compensation Table.
The SEC decided not to rescind the requirement to report the full grant date fair value of each equity award in the Grants of Plan-Based Awards Table and the Director Compensation Table. While in some ways duplicative of Summary Compensation Table disclosure under the revised rules, the adopting release indicates that the SEC viewed this itemized disclosure as helpful in allowing shareholders to evaluate decisions of the compensation committee by seeing the value associated with each type of equity award granted.
Enhanced disclosure about directors and director nominees Under the SEC’s new rules, companies need to disclose the particular experience, qualifications, attributes or skills that led the board to conclude that each director and director nominee should serve as a director of the company, in light of the company’s business and structure. The new disclosure is required for all nominees and all directors, even those not up for reelection in a given year. If material, this disclosure should cover more than the past five years, as currently required, and should also include information about the person’s risk assessment skills, particular areas of expertise and other relevant qualifications. Unlike the proposed rules, disclosure is generally not required with respect to the experience, qualifications or skills that qualify a person to serve as a committee member, unless an individual is chosen to be a director or nominee because of a particular qualification, attribute or experience related to service on a specific committee, such as the audit committee.
Companies are now required to disclose any public company directorships held at any time during the past five years by a director or nominee. In addition, the new rules require disclosure of any material legal proceedings in which a director or director nominee was involved during the prior ten years (an increase from the current five-year period) and expand the types of legal proceedings for which disclosure is required. These additional legal proceedings include judicial or administrative proceedings resulting from involvement in mail or wire fraud or fraud in connection with any business entity, proceedings based on violations of federal or state securities, commodities, banking or insurance laws and regulations (and settlements to such actions), and disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other self-regulatory organization.
The final rules added a requirement to disclose whether, and if so how, a nominating committee considers diversity in identifying nominees for director. In addition, if the nominating committee or the board has a policy relating to the consideration of diversity in identifying director nominees, disclosure is required as to how the policy is implemented and how the committee or the board assesses the effectiveness of the policy.
Board leadership structure Under the new rules, additional proxy statement disclosure is required to describe the board leadership structure. This includes discussion of whether the same individual serves as both principal executive officer and chairman of the board, or whether two different individuals serve in those capacities. If it is a single individual, the company must disclose whether it has a lead independent director and describe the specific role the lead independent director plays in the leadership of the company. The company is also required to explain why it believes that its leadership structure is appropriate given the company’s specific characteristics or circumstances. The extent of the board of directors’ role in the company’s risk oversight must also be disclosed.
Compensation consultants Previously, required disclosure regarding compensation consultants was limited to a narrative description of their role in determining or recommending the amount or form of executive and director compensation, identifying such consultants, stating whether such consultants are engaged directly by the compensation committee, describing the nature and scope of their assignment, and the material elements of the instructions or directions given to consultants with respect to the performance of their duties under the engagement. Companies were not required to disclose the fees paid to such consultants.
The final rules expand the existing disclosure requirement, providing for disclosure regarding the fees paid to compensation consultants and their affiliates when they play any role in determining or recommending the amount or form of executive and director compensation, if they also provide other services to the company and the fees for those other consulting services exceed $120,000 during the company’s fiscal year. Additionally, the new rules require disclosure as to whether the decision to engage the compensation consultant or its affiliates for non-executive compensation consulting services was made or recommended by management, and whether the board has approved these services. The proposed rules would have also required a description of additional services provided to the company by a compensation consultant and its affiliates, but the final rules did not include this requirement.
As an exception to this requirement of fee disclosure, the final rules provide that the fee and related disclosure is not required about consultants that work with management (whether for only executive compensation consulting services, or for both executive compensation consulting and other non-executive compensation consulting services) if the board has its own consultant.
The final rules also provide that services involving only broad-based non-discriminatory plans or the provision of information, such as surveys, that are not customized for the company or that are customized based on parameters that are not developed by the consultant are not treated as executive compensation consulting services for the purpose of these new rules.
The adopting release indicates that these disclosures are intended to enable investors to assess any conflicts a compensation consultant may have in recommending executive compensation and to better assess the compensation decisions made by the board of directors.
Report of voting results from shareholder meetings on Form 8-K The new rules mandate that a reporting company disclose the vote results from a shareholder meeting on Form 8-K generally within four business days after the meeting. Previously, voting results were not required to be reported until the filing of a company’s next Form 10-Q or Form 10-K. If final voting results are not available within four business days, a company must file the preliminary voting results and then file an amended Form 8-K within four business days after the final voting results are known.
These rules reflect the increased scrutiny of public company compensation and governance practices on the part of shareholders, investors, regulators and Congress, and can be seen as part of a continued effort by the SEC to provide for increased disclosure of compensation and corporate governance related items. The adoption of these rules so close to the end of the calendar year will make it exceptionally important for companies to rapidly evaluate the impact of these changes both on disclosure to be contained in their upcoming proxy statements and on year-end compensation decisions.